Exchange rate determination.


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Exchange rate determination.

  1. 1. Abstract of the paper This paper develops an equilibrium model of the determination of exchange rates and prices of goods. Changes in relative prices of goods, due to supply or demand shifts, induce changes in exchange rates and deviations from purchasing power parity. These changes may create a correlation between the exchange rate and the terms of trade, but this correlation cannot be exploited by the government to affect the terms of trade by foreign exchange market operations.
  2. 2. INTRODUCTION Exchange rate and their rate of change are more volatile than the change of the relative price. Frequent changes in the exchange rate have failed to resemble contemporaneous changes in the relative price level in either magnitude or direction Problem in determination of equilibrium .
  3. 3. Therefore, This paper proposes an alternative equilibrium explanation of ex- change rate behavior. The explanation is based on a model of the simultaneous determination of exchange rates and relative prices of different goods in international trade in an intertemporal framework with uncertainty and rational expectations
  4. 4. Key points of the paper Exchange rate may be volatile i.e. changes in the exchange rate will be more than the changes in the relative prices of good in two countries The exchange rate and the term of trade cannot exploited by the government Creates uncertainty even when all markets are in equilibrium Deviates from PPP Correlation of the exchange rate and the term of trade for the countries with homogenous monetary policy
  5. 5. •These relative price changes were emphasized in the traditional literature on exchange rates but have been neglected in the recent exchange rate literature associated with the monetary approach. •Government commercial policies such as tariff's or quotas can, however, affect the exchange rate by changing the terms of' trade. Cassel (1922) (discussed the role of commercial policies in causing deviations from purchasing power parity. Muss (1974) examined the effects of commercial policies on the balance of' payments, and his argument could be applied to flexible exchange rate case; the effect he emphasizes is the change in real income and hence the domestic demand for domestic money due to a tariff.
  6. 6. Factor affecting determination of exchange rate  Inflation rates: Higher domestic inflation means less demand for domestic goods and more demand for foreign goods (increased demand for foreign currency), causing increasing in exchange rate i.e. depreciation of domestic currency.  Interest rates: Higher domestic (real) interest rates attract investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.  Economic growth: Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.  Changes in future expectations: Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency .  Government intervention: Maintain weak currency to improve export competitiveness.
  7. 7. INTRODUCTION A theory of long-term equilibrium exchange rates based on relative price levels of two countries.  The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries' currencies by changes in the countries' price levels.  Law of one price Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. This law applies only in competitive markets, free of transport costs and official barriers to trade The Relationship Between PPP and the Law of One Price •The law of one price applies to individual commodities, while PPP applies to the general price level. •If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries if each commodity is traded.
  8. 8. TWO TYPES OF PURCHASINGPOWERPARITY 1. Absolute Purchasing Power Parity 2. Relative Purchasing Power Parity The Absolute Purchasing Power Parity relation is: e= pd/pf where pd is the domestic price index, pf the foreign price index, and e is the spot exchange rate (domestic currency units per unit of the foreign currency). Relative PPP is said to hold if e=pd - pf Relative PPP states that the percentage change in the exchange rate is equal to the percentage change in the domestic price level minus the percentage change in the foreign price level
  9. 9. Absolute PPP indicates that the exchange rate between two currencies is equal to the ratio of the two countries’ price indexes. The exchange rate is a nominal value, that is, its value is dependent on current price levels. If absolute PPP holds, then relative PPP also holds. If absolute PPP does not hold, relative PPP may still hold. Real events (demand and supply socks) which cause relative price changes are often random or unexpected
  10. 10. Problems with Law of One Price The more homogeneous goods are, the more the law of one price is expected to hold but it could not be found in reality There are obstacles to equalization of product prices across countries, including differentiated products and costly information. Transportation cost and restricting trade policies (such as tariff and quatas are present)
  11. 11. Reasons for Deviations from PPP The law of one price does not apply to differentiated products or to globally non-traded goods. Prices may differ due to freight costs or tariffs. Relative price changes may result from real economic events such as changing tastes, bad weather, or government policy. Since people in different countries consume different goods, national price indexes may not be comparable.
  12. 12. Assets market approach for the determination of exchange rate Monetary approach Deals with the demand and supply of money Portfolio approach The portfolio balance approach points out the imperfect substitution between home assets and foreign assets .
  13. 13. Monetary approach Change in exchange rate due to change in demand or supply of money Demand for money is the Increasing function of income and the decreasing function of interest rate. If, e= pd- pf then
  14. 14. Exchange rater depends upon,  Difference in the demand for money  Difference in the income  Difference in the rate of interest e If, mf If, id & e If, md
  15. 15. (Cont.) An increase in domestic money supply causes an excess money supply and results in a price increase in home country and a depreciation of domestic currency. An increase in domestic national income brings about more money demand , the exchange rate falls or in other words, domestic currency appreciates. A rise in home interest rate reduces money demand and causes the price level to increase. The exchange rate then rises causing domestic currency to depreciates. A rise in the expectation of future exchange rates will result in an immediate depreciation of domestic currency.
  16. 16. Model emphasized Role of relative price change due to real disturbance . Traditional elasticity theory Exchange rate
  17. 17. Change in money supply Change in stock of money Increases the nominal prices of good and service Increases the nominal prices of foreign exchange
  18. 18. Relative price change and exchange rate Nominal price change in each country Exchange rate Terms of trade Cause Shifts in the demand and supply Correlation is high for the country with more homogenous monetary policy
  19. 19. Relationship of terms of trade and exchange rate Appreciation the currency Favorable terms of trade Depreciation of currency Unfavorable terms of trade Terms of trade: ratio of the export price/import price px/py for country1 py/px for nation 2 ,
  20. 20. Relationship with inflation and the exchange rate High inflation in the country Low inflation in the country depreciation appreciation Countries with persistently high levels of inflation tend to experience exchange rate depreciation, while low inflation countries have appreciating exchange rates. Thus, inflation and exchange rates tend to move in opposite directions . There is an inverse relationship between the two variables. Inflation only affects purchasing power if the rise happens unevenly across prices of goods and factors of production acros the world.
  21. 21. o Ms1 and Ms2 are nominal quantities of money supply . o P1 and P2 is the price of good one and good two. o Country one is the domestic country and country two is the foreign country. o e is the exchange rate where, e=Pd/Pf
  22. 22. Assumption The real quantity of money supply remains constant for each country i.e.M1/P1 and M2/P2 is constant over time. The relative prices of one good in terms of other good = T=P1/e*P2(T = relative prices of goods)  If relative price shifts i.e. price of good one increases and price of good two decreases then demand for good two increases and good one decreases.
  23. 23. T= Pd/e*Pf T Pf e=Pd/Pf Pd=e*Pf Demand for the domestic goods decreases, and foreign good increases leading to appreciation of the foreign currency and depreciation of the domestic currency. Exchange rate is high in domestic country-depreciation of the currency Exchange rate is low in foreign country-appreciation of the currency
  24. 24. Rational expectation Md=f (i, e∏) Where, md = demand for money, I = rate of interest e∏ = expected inflation rates we can know, 1 future rate of monetary growth 2 inflation on the current exchange rate and the price level If the expected inflation is going to increase the domestic currency will depreciates.
  25. 25. Relationship between exchange rate and relative prices. ASSUMPTION OF THE MODEL. •Money is only used for precautionary purpose and transactioanary purpose •Real demand for money is not constant .i.e. M1/P1 and M2/P2.] • A change in relative price T is partially effected by e and partially effected byP1 and P2. •Good1 is produce in country 1and good 2 is produce in country 2 •Goods are not stored. •Complete specialization •Shocks to production is independent across good and over time
  26. 26. Individual 1= domestic country (1) Individual 2=foreign country (2) Utility maximization of individual 1 Where, C11, C12 Shows the consumption of individual 1 U1 is the current period utility function β (0,1) Is the discount term Utility maximization of individual 2 Output=(Y1 , Y2)
  27. 27. Subject to the constraints. INDIVIDUAL 1 BUDGET CONSTRAINTS LIQUIDITY CONSTRAINTS Where, c11 and c22 - consumption of good 1 and good 2 m11- domestic money, m12- foreign currency e - exchange rate t1-Tranfer payment of m1 to individual 1 (negative values if taxes) m’11 and m’12 holding of domestic and foreign currency at the end of the period Individual 2
  28. 28. Role of the government To determine transfer payment or taxes (T1, T2) Buying or selling of foreign exchange Ms 1 and Ms2 –nominal quantities of money 1 and 2 at the beginning of the period Ms1=m11+t1+m12 Ms2=m22+t2+m21 At the end of the period, f=foreign exchange market intervention taken by govt. M’s1=Ms1+f M’s2=Ms2-1/e*f Equilibrium condition, C11+c12=y1 C12+c22=y2 m’11+m’21=ms’1 m’12+m’22=ms’2 Equilibrium price vector=p=(p1, p2, e)
  29. 29. DEMAND FUNCTION STATE VECTOR(s) Prices of domestic goods and foreign good Output Y1,Y2 Transfer income reserves the nominal money supply (m1, m2) State vector Government intervention (G) S=(y1,y2,y11,y12,ms1,ms2,G) P=(P1,P2,E); P=f(s) Exchange rate Demand for domestic currency Domesti c& Foreign currency Demand for foreign currency C=f(pd, pf, e, md, mf, R, t )
  30. 30. Dynamics of the model State vector Prices of good changes Exchange rate changes Changes because Changes in money supply Governmen tinterventio Changes in real income Future expectation
  31. 31. Expectation of the individual The model gives more emphasis to the rational expectation of the individual on the expected Value of the future money growth and the future inflation rate. Given the expectation of the future values the individual will be able to formulate his demand And prices of the commodity The individual is assumed to be rational and wants to maximize his utility to attain equilibrium
  32. 32. Income effect and the substitution effects If substitution effects dominates the income effects, then increase in the initial holdings of money will increase both demand for goods and demand of money Increase in price of domestic good increases the demand for both (md,mf)currency and the demand for good two, therefore the domestic currency depreciate and foreign Currency appreciates . Increase in the exchange rate of domestic currency i.e depreciation of domestic currency Increase the demand for both domestic good and domestic currency.
  34. 34. INTEREST RATE vs. EXCHANGE RATE CURRENT ACCOUNT vs. EXCHANGE RATE GDP vs. INTEREST RATE INFLATION vs. EXCHANGERATE Whenever the interest rate rises return on investment increases , both for private and public investors. When interest rate raises the country currency appreciates .The main reason behind this appreciation is that more and more people come inside the county and invest more . When there is a surplus balance in the current account the home currency appreciates while in case of the deficit in the current account the home currency depreciates When the gross domestic product increase it , leads the home currency depreciation. So the gross domestic product is influencing the exchange rate fluctuation. When the inflation rate of a country increases the currency Depreciate because inflation is inversely related to the value of currency.
  35. 35. CONCLUSION 1 Forces That Causes Changes In The Exchange Rate Also Causes Changes In The Term Of Trade 2 Real Supply And Demand Shocks Affects Both Relative Prices As Well As Derived Demand For Foreign Exchange 3 If The Relation Ship Between Exchange Rate And Term Of Trade Is Due To Shifts In Real Supply And Demand For Foreign Good And Domestic Good Than Government Intervention In Foreign Exchange Market Could Not Effects The Exchange Rate